Evergrande: Internalizing the Impacts of Moral Hazard
Outlined the major differences between Huarong and Evergrande, the challenge regulators face with the overindebted real estate firm, and the impact financial distress will have on the domestic economy
For years Chinese regulators ignored the risks associated with highly leveraged real estate developers by allowing risky borrowing practices to persist in order for Provincial Governments to meet GDP growth targets. At the end of 2020, regulators released the ‘Three Red Lines’ policy, designed to reign in the developers. The current precipitous fall of Evergrande shocked offshore market participants and generated panic among onshore owners of Wealth Management Products. Once again China’s Central Government is faced with a debt market predicament in open sight.
To manage the largest rural to urban migration in human history, China’s real estate market was supported by all levels of Government. Rapid urbanization necessitated expanded industrial capacity to produce building materials and additional housing. The feedback loop between urbanization and industrial production become central to China’s continuous economic expansion. As construction started to occur in anticipation of migration, empty units began to accumulate. A tremendous amount of attention was given to China’s ghost cities, but very few questions were asked about the socialization of losses associated with these boondoggles- partially because the backstop of NPL managers such as Huarong.1
Chinese authorities attempted to redirect the country’s state-led capitalist model towards advanced manufacturing and other new priorities by capping the leverage of China’s real estate developers. The balance sheet restrictions led to illiquidity which has now reverberated through the market and allowed for contagion risks to expand. Individual stakeholders are increasingly nervous about the status of their real estate investments, resulting in property sales declines. Now financial distress costs extend into the real estate sector’s supply chains. Current delays to a resolution not only exacerbate the damage to a key driver of Chinese growth, but also express the complexity of pivoting away from the real estate sector’s industrial cycle.
As the private sector waits, the economy decelerates. From an external perspective, a slowdown in Chinese growth echoes through markets in the form decreased Chinese materials demand and an increase in China’s excess capacity and exports.2 Internally, Provincial Government finances deteriorate with a decrease in land sales. In many Provinces, as much as one third of total revenues come from land sales. Lou Jiwei, former Minister of Finance, was quoted saying “according to a rough calculation, about a quarter of the Provinces will use half of their fiscal revenues to repay capital with interest”. A decline in revenue forces Provincial Governments to expand leverage, transferring the debt growth from one sector in the Chinese economy to another. Most likely, this will result in the continued expansion of extended maturities within the Provincial bond market.3
For China, it is much easier to deal with non-performing assets behind closed doors. Central Government support for a central state-owned enterprise is a much less challenging decision than socializing the debts of an integral element of the private sector with cross Provincial exposure. If private investors are forced to internalize loses, the financial contagion will generate exceedingly costly and destructive impacts. Stabilizing, bailing out, Evergrande would reinforce issues related to moral hazard in an overleveraged real estate sector and result in a more unstable economic future, but would help stabilize a key driver of economic activity.